When constructing a portfolio, we often look at instruments that have a relatively small correlation. If instruments are placed in a portfolio that have been shown in the past to react differently to each other, this leads to a diversification effect. In other words, the (weighted) sum of the parts of the risk is greater than the total risk in the portfolio. This is the fine side effect of a well-diversified portfolio, but what should you pay attention to in times of crisis?
09 Jun 2020
History ≠ future
Important is the fact that history does not repeat itself 1-on-1 in the future. For example, historically, the correlation between equities and government bonds is virtually zero. This means that they do not move with each other in an average period. However, in a non-average period they will probably move strongly with each other (or not at all). If an analysis is based on a static assumption regarding the correlation between investment categories - as in the case of Solvency calculations, for example - this leads to an under- or overestimation of the risk of the portfolio.
In times of stress, many instruments often go down in value because investors like to focus on certainty in those times. In addition to the fact that returns will often be negative in times of crisis, there is also only a limited diversification advantage between the various types of instruments in the portfolio. In other words, the correlation between the instruments increases, which means that the risk of the portfolio is higher than previously estimated, in addition to the already higher risks observable in the market at that time.
Assuming higher correlations
From the point of view of risk management, it is advisable to look at situations in which the scenario occurs in times of crisis. An example of such an analysis could be a variant in which you assume higher correlations between instruments / economic variables than can be assumed on the basis of history. This means that all instruments in such a scenario move more similar to each other. With an increasing correlation between variables, the diversification effect becomes smaller. Ask yourself the question: To what extent will the risk of the portfolio increase if the diversification effect is unexpectedly lower? And does this still fit within the bandwidths of my risk appetite?
Being prepared in advance for unexpected situations is the most important goal of Risk Management. In the next article we look at the volatility of investment categories.
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